Doctoral thesis of philosophy domestic transfer pricing in services a value chain framework

The objective of this research is to explore the domestic transfer pricing practices of service organisations in Australia with the emphasis placed on examining whether, in internal tran

RMIT UNIVERSITY SCHOOL OF ACCOUNTING AND LAW

DOMESTIC TRANSFER PRICING IN SERVICES:

A VALUE CHAIN FRAMEWORK

Submitted in fulfillment of the requirements for the degree of

Doctor of Philosophy

by

Bϋlend Terzioglu

August 2006

The gap in the literature on transfer pricing in the service sector applies equally in the Australian setting This is despite the significant and increasing contribution of the service sector to both GDP and employment

The objective of this research is to explore the domestic transfer pricing practices

of service organisations in Australia with the emphasis placed on examining whether, in internal transactions, the domestic transfer price had any influence on the value perceived by the internal buyer Because the extant transfer pricing theories cannot explain the value perceived by the internal customer in internal exchange of goods and services, an exploratory research methodology is adopted and no assumptions are made about the relationship

Data were gathered from survey responses from eighty service organisations and thirteen face-to-face interviews Survey data were sought at two levels Questions

of a strategic nature were directed to corporate management while questions pertinent to transfer pricing and value were sought from the divisional management who are actually involved in such transfers Exploratory factor analysis was used to analyze the data

The findings indicate that cost-based transfer pricing was the most preferred method, and in internal transactions, and responsiveness of the internal supplier was the key factor for internal buyers The research found that service organisations are external customer oriented and internal customer issues are secondary The research results also demonstrate that no significant association exists between transfer pricing and internal customer perceived value

The current research contributes to the transfer pricing literature by providing insights to locus of transfer pricing decisions, transfer pricing methods employed by service organizations in Australia, objectives of transfer pricing systems, conflicts arising during from the transfer pricing process and the role of transfer prices on the value perceived by internal customers As a research topic, this study is pioneering as it integrates for the first time, the constructs of transfer price and value in internal transactions Another unique feature of this research is that it was carried out in another important but under-researched context of service organisations

Para Topic Page

2.1.6.1 Transfer pricing methods used for international transfers 50 2.1.6.2 Transfer pricing methods used for domestic transfers 51

2.1.6.5 Transfer pricing and out-sourcing decisions 53 2.1.6.6 Transfer pricing studies conducted in Australia 56 2.1.6.7 An evaluation of methodologies employed in previous

studies

58

2.1.6.8 Transfer pricing in service industries 60

2.2.1 External customers and internal customers 68 2.2.2 Arguments about the internal customer concept 69 2.2.3 Association between satisfaction of internal customers

and external customers

2.3.5 Significance of the customer perceived value 87 2.3.6 Customer perceived value and service quality 89

Para Topic Page

2.3.7 Customer perceived value and customer satisfaction 89 2.4 Value chain analysis and competitive advantage 90

2.4.2.3 Customer perceived value and competitive advantage 96 2.4.2.4 Competitive advantage for service industries 97

3.5.2.1 Rationale for using the written questionnaires 126

3.5.2.5 Administration of the questionnaires 130

Para Topic Page

4.1.7 Breakdown of respondents by responsibility centres 140

4.1.12 External market for internally provided services 143

4.1.15 The role of the chief financial officer in setting transfer

prices

145

4.1.17 Circumstances that prompt a change in transfer price 146 4.1.18 Objectives of transfer pricing system 147 4.1.19 How firms determine if transfer pricing objectives have

been achieved?

150

Para Topic Page

4.1.21 Rationale for multiple transfer prices 162

4.1.28 Freedom to out-source internally provided services 177

4.1.32 Importance of the internal customer perceived value 184 4.1.33 Internal value creation and setting transfer price 187 4.1.34 Customer value and competitive advantage 189 4.1.35 Association between satisfaction of internal and

external customers

190

4.1.38 Sustainability of competitive advantage 202

4.1.41 Monitoring operations to keep costs under control 207

4.1.44 Emphasis in marketing communications 208 4.1.45 Development of new service products 209

Page

4.1.48 Offering superior service products than competition 212

Para Topic Page

4.2.16 Rotated component matrix and discussion of findings 236

LIST OF TABLES

Table 2.2 Breakdown of empirical studies carried out since 1956 48 Table 2.3 Objectives of transfer pricing for international transfers 50 Table 2.4 Transfer pricing bases for international transfers 51 Table 2.5 Prior studies on transfer pricing in service industries 61 Table 2.6 Previous research on applicability of SERVQUAL for

measuring service quality

84

Table 2.8 A comparison of SERVQUAL and SERVPERF 88

Table 4.1 Profile of the sample and response rate 135 Table 4.2 Comparative sample sizes on domestic transfer pricing

surveys

136

Table 4.3 Profile of interviewed organisations 138

Table 4.15 External market for services 143

Table 4.18 Role of chief financial officer (CFO) in setting prices 145 Table 4.19 Frequency of transfer price reviews 146

Table 4.21 Transfer pricing objectives – ranking by importance 148 Table 4.22 Transfer pricing objectives-descriptive statistics 148 Table 4.23 Comparison of transfer pricing objectives reported under

Table 4.25 Mostly used transfer pricing bases – current study 152

Table 4.27 Transfer pricing systems employed between responsibility

centres

157

Table 4.28 Single versus multiple transfer price 162 Table 4.29 Rationale for using multiple transfer pricing bases 163 Table 4.30 Frequency of transfer pricing conflicts 164 Table 4.31 Satisfaction with the current transfer pricing system 165

Table 4.34 Adoption of Activity-Based Costing (ABC) 172

Table 4.39 Importance of lowest sources of supply 180

Table 4.41 Proportion of inter-divisional trade (expressed as a

percentage of total company sales)

182

Table 4.42 Value definition (Corporate perspective) 183 Table 4.43 Importance of value creation for internal customer in

setting transfer price

187

Table 4.44 Relationship between value created for internal customers

and competitive advantage at product level

189

Table 4.45 Relationship between satisfaction of internal customers

and external customers

190

Table 4.48 Sources of competitive advantage – mean scores 201 Table 4.49 Sustainability of sources of competitive advantage 203

Table 4.52 Monitoring operations to control costs 207

Table 4.57 New service products for internal customers 210

Table 4.64 Kaiser-Meyer-Olkin and Bartlett’s Test 221

Table 4.66 Reliability scores (Cronbach’s alpha) 227

Table 4.68 Interpretation of correlation co-efficients 234

LIST OF FIGURES

Figure 1.4 The two perspectives of customer value 27

Figure 2.1 External markets versus internal markets 64

Figure 2.4 First Order Factor Model for Customer Value 82

Figure 4.1 Value chain of a telecommunications company (B) 195 Figure 4.2 Value chain of a telecommunications company (J) 196 Figure 4.3 Value chain of funds management of a major bank (C) 197

LIST OF APPENDICES 284

Appendix A – Introductory letter / Interview 286 Appendix 1B – Introductory letter / questionnaire 287

Appendix 2A- Follow-up letter / interview 289 Appendix 2B-Follow-up letter / questionnaire 290

Appendix 3A – Questionnaire / Corporate 292 Appendix 3A1 – Source-motivation for questionnaire 302 Questions / Corporate

Appendix 3B – Questionnaire / Division 304 Appendix 3B1 – Source-motivation for questionnaire 313 Questions/Division

Appendix 4A –interview guide / Corporate 316 Appendix 4A1-Source-motivation for interview 324 questions / Corporate

Appendix 4B – Interview guide / Division 326 Appendix 4B1-Source-motivation for interview 335 questions / Division

APPENDIX 7 Skewness and Kurtosis statistics 361

ACKNOWLEDGEMENTS

First, I wish to acknowledge gracious support and guidance of my lead supervisor Professor Robert Clift It would not have been possible to complete this thesis on time without his trust and encouragement He has always been inspiring, supportive and patient and I just cannot find words to describe Professor Clift’s contributions to this thesis I am grateful for all he did I am also grateful to Mr Robert Inglis, my supervisor, who was always professional and willing to help when

I needed assistance He was very professional and supportive throughout the research process Even at certain stages of the project when there was extreme stress and time pressures, both Professor R Clift and Mr Robert Inglis were always encouraging and understanding Their unwavering enthusiasm and commitment have enhanced my motivation

I would like to express my thanks to Professor Philomena Leung, my first lead supervisor, for her professionalism and guidance My thanks also go to Prof Sheila Bellamy for allowing the extra time for the completion of this project, and to Prof Clive Morley, for his friendly approach and helpful feedback

In addition, I also would like to thank academics both in Australia and abroad, who responded to my various inquiries about their research or those who reviewed the interview and questionnaire items

I am grateful to several anonymous busy executives who were kind enough to take time to complete and return the questionnaires as well as those who made themselves available for the interview

My heartfelt thanks also go to my wife and children for their understanding and support over the past six years

This was a rather long and stressful road to travel alone, but, the thoroughly professional and friendly approach and guidance of both of my supervisors turned

it into an enjoyable scholarly journey which, I shall cherish all my life

Thank you

DECLARATION

I, Bulend Terzioglu, hereby certify that:

a except where due acknowledgement has been made, the work is mine alone;

b the work has not been submitted previously, in whole or in part, to qualify for any other academic award;

c the content of the thesis is the result of the work which has been carried out since the official commencement date of the research program

d Occasionally, I have asked a colleague of mine, Alan Dymond, a lecturer at James Cook University, to check the language of some selected sections which amounted to typically maximum a few pages at a time

e I have used paid services of a Smartdocs to get some of the interviews transcribed

Signed

CHAPTER 1 – INTRODUCTION

This chapter presents a background to the areas under investigation, explains why the researched topic is important and the expected contribution of the research outcomes to both academia and practitioners

1.1 Overview of the research topic

The principal objective of the present research is to examine empirical relationships between transfer pricing (the prices at which goods and services are exchanged between divisions of the same company) and internal customer perceived value in service organisations in Australia As recommended by Tang (1992), in consideration of the complexity and multi-dimensionality of the transfer pricing issue, a multi-disciplinary approach was adopted The topic under investigation is concerned with accounting, marketing, services marketing and management and quality management literatures In the accounting literature, Emmanuel and Mehafdi (1994) begin to inquire about the impact of transfer prices

on the value perceived by internal customers where value is defined as the overall assessment of the buyer of what is received and what is given (Zeithaml, 1988) Their curiosity is to find out if internal divisions treat each other as customers, and

as a consequence, if internal transfer price charged by the supplying division does affect the perception of value of the buying division It is believed that better internal customer satisfaction and provision of superior value to internal customers would eventually improve overall financial performance of the organisation (Heskett and Schlesinger, 1994; Schneider and Bowen, 1985) However, one of the key components of an internal transaction is the price charged between divisions for the services they perform The effect, if any, of internal transfer price on internal buyer’s perception of value has not been investigated to-date

This research aims to examine this issue on service industries which also have been long ignored in the accounting literature As discussed in more depth in the following paragraphs, services make up a growing proportion of developed economies’ gross domestic product

The current research is also the first empirical attempt to investigate the relationship between the domestic transfer price and internal customer perceived value The rationale for the research is discussed in greater detail under Literature Review (Chapter 2) Today’s business environment, and particularly the services landscape, faces more challenges than ever before Rapid technological changes, out-sourcing, continued deregulation, the emergence of the global village, the increasingly competitive nature of most markets and rising consumer expectations present formidable challenges as well as opportunities (McColl-Kennedy, 2003; Lovelock, Patterson and Walker, 2001) The dynamic nature of the market place necessitates that organisations develop, possess and sustain some kind of competitive advantage either in the form of performing similar operations at a lower cost or differentiating themselves in ways valued by their customers (Porter, 1985; Day and Wensley, 1988) or both (Thwaites, Walley and Foots, 1996; Baden-Fuller

and Stopford, 1994; D’Aveni, 1994)

While there seems to be agreement on the importance of achieving and sustaining competitive advantage (Porter, 1985; Schnaars, 1991), views differ as to its sources Hay and Williamson (1991) claim that the concept of competitive advantage is a deceptively simple idea of assessing a company’s capabilities and market position by how they provide advantage relative to competitors A firm’s competitive advantage stems from its own ability to create and sustain value for its buyers that exceeds the firm’s cost of creating it (Porter, 1985; Ravald and Gronroos, 1996; Woodruff, 1997; Parasuraman, 1997), from the quality and commitment of the labour force (Lovelock and Yip, 1996; Berry, 1981), through superior resources, superior skills and superior controls (Ravald and Gronroos, 1996; Day and Wensley, 1988) Heskett, Sasser and Schlesinger (1997) and McCarthy (1997) report that there is association between the sound internal structures and processes and satisfaction of external customers

The flow of internal activities and the value creation during the internal exchange of services are illustrated in Figure 1.1 The aggregate net value obtained at the end

of the activity chain presumably affects the value that the final (external) customer will receive The domestic transfer price is considered a component of the total cost incurred by the internal buyer

Activity A Activity B Activity C Activity D

EXTERNAL CUSTOMER

Net Value

NET VALUE GENERATED

VA- CA VB - CB VC - CC VD - CD

INTERNAL DIVISIONS

1.2 Two types of customers

As depicted in Figure 1.2, the term “customer” falls into two categories: external customer and internal customer External customer refers to the consumer or organisation that is not affiliated to the firm and who is the end user of a firm’s products or services while internal customer refers to employees or departments that directly interact with customers and sell, service, maintain, or troubleshoot for other departments or functions in the company (Zeithaml and Bitner, 2003) That is

to say internal customer is the division within the firm that receives the work of another and then adds its contribution to the product or service before passing it on

to the next division Although several researchers distinguish between these two types of customers, Gummesson (1987) believes that there should be no such distinction between external and internal customers because everybody in an organisation is both an internal customer and supplier of goods or services to other internal customers

Figure 1.2

Types of customers

External Customers

Internal Customers

Employees as customers (internal marketing) Gronroos (1985)

Internal buyers as customer

(Zeithaml et al (1996)

Customers

1.2.1 External customers

For the reason that they pay for the final good/service and thus influence an organisation’s revenues, firms often give precedence to the satisfaction of external customers at the expense of internal customers Similarly, the marketing literature affords relatively greater attention to external customers Much of the empirical research to-date focused on the service quality issues relating to external customers (Zeithaml, Parasuraman and Berry, 1990; Woodruff, 1997) As one of the fervent proponents of external customer orientation, Harari (1991), questions if internal customers should even exist at all, and reports that each person’s focus should be on the outside because internal satisfaction is irrelevant to the end goals

of the organisation Harari’s (1991) claims, however, are not research-based and are anecdotal In the literature, the internal exchange and satisfaction of the needs within the organisation remain overlooked, and Lusch, Brown and Brownswick (1992) believe the topic requires systematic investigation

1.2.2 Internal customers

Internal transactions take place between divisions of the firm before the final good

or service is delivered to the external customer Literature distinguishes between two types of internal customers First, Berry (1981) views employees as customers

of an organisation as internal customers whose satisfaction and motivation could

be utilised to enhance external customer satisfaction To this end, Berry (1981) suggests that organisations should aim to attract, develop, motivate and retain qualified employees and utilise them at jobs that can satisfy their needs Consequently, treatment of employees as customers is anticipated to result in employee satisfaction (Berry and Parasuraman, 1991) In the same way, George (1977) also claims that satisfied employees are pre-requisite to having satisfied external customers

Although the importance of satisfying customers is a central theme in marketing (Barnes, 1989), the emergence of the notion of ‘internal customer’ is rather recent The internal customer concept used in this research is different from the internal customer notion Berry (1981) describes

Following Zeithaml, Berry and Parasuraman (1996), the internal customer, for the purposes of this research, refers to a division that buys goods or services from another division within the same organisation The key differentiation of the internal customer definition from the employee referred to by Berry (1981) is the emphasis

in each definition The definition adopted in the current research is not directly concerned with the buyer as an employee, rather, it views the buying division as a customer Given the attention which has been given to study the characteristics of organisational effectiveness from the perspective of those who are the organisation’s external customers (Parasuraman, Zeithaml and Berry, 1985; Zeithaml, Berry and Parasuraman, 1996; Fisk, Brown and Bitner, 1993; Nicholls, Gilbert and Roslov, 1998; Taylor, 1994), much less has been reported about organisational effectiveness from the perspective of internal customer satisfaction

1.3 Value

There are difficulties in providing a definition of value on which many people may agree Major domains of value include shareholder value, employee value and customer value (Figure 1.3) Shareholder value refers to the value that the organisation delivers to its shareholders which is usually measured using economic value added, market value added and shareholder value added (Cornelius and Davies, 1997) On the other hand, employee value has two perspectives First, the value that the employees deliver to the organisation and second, the value that organisation delivers to its employees The value that organisations provide to employees has hardly received any academic interest whereas the value that employees deliver to organisations through their skills, job performance, etc., is examined by various researchers (Anderson and Oliver, 1987)

The value is defined by Porter (1985) as the amount buyers are willing to pay for what the firm provides This definition of value is consistent with this research which attempts to gain insights from the customer’s perspective Smith and Nagle (2002) state that the customer value represents the objective worth to a customer

of satisfying the benefits he or she seeks from a product or service The customer value may be broken down to three categories

First, the customer value means the value customers deliver to the organisation which is concerned with the profits obtained from customers over their lifetime with the organisation (Payne, Holt and Frow, 2000) Second, external customer value refers to the difference between the net value, the difference between the costs and benefits of transaction that accrues to the external customer Third, internal customer value is concerned with the net value –difference between costs to and benefits perceived by internal buyers during internal exchange of goods or services Albrecht (1992) highlights the connotation between quality and customer value and contends that delivering customer value is the only thing that matters in the new world of quality

It is always the customer that counts regardless of whether the customer is external or internal For this reason, only when the customers are satisfied, has the job been properly executed It is believed that the inability of an organisation to create value for internal units may restrict its ability to create value for external customers In recognition of the growing importance of internal customers, organisations are now encouraged to focus on internal processes and aim to deliver value to their internal customers (Naumann, 1995; Gale, 1994; Day, 1990) The development of Business Process Reengineering in the late 1980s shifts companies’ focus to their internal processes and urges them to find ways to improve the efficiency of their processes that occur in their supply chains so that the net value accrues to the external customers

Although the importance of providing superior quality to internal customers has been repeatedly stressed, prior studies have often failed to examine internal transactions from a value point of view The value of the service exchanged as perceived by the internal customer (internal customer perceived value) constitutes one of the pillars of this research Internal customer perceived value is defined as the internal customer’s overall assessment of what is received and what is given (Zeithaml, 1988) Also, value lies at the heart of competitive advantage and the primary objective of most service organisations is to achieve external customer satisfaction (Jones and Sasser, 1995) through providing value

In order to provide value, organisations are encouraged to understand what creates value in the first place (Lichtenhal, Wilden and Long, 1997)

Figure 1.3

Value hierarchy

1.3.1 External customer value and internal customer value

The marketing literature affords relatively greater attention to the value the customers deliver to organisations than the value that organisations deliver to their customers

Shareholder value

Employee value

Customer Value

VALUE

Value employees provide to organisation

External Customer value

Internal Customer value

Value organisation provides to organisation

Value of external customer

to an organisation

Figure 1.4

The two perspectives of customer value

Sommers (1999) who surveys the banking industry in the U.K., notes that for many banks, the term “customer value” is used solely to refer to the value of the customer to them, rather than the value they create for the customer In this context, the term value involved attributes that are important for the customer in meeting their needs One disadvantage of this approach is the narrow focus on internal processes at the expense of external factors and concentrating on customer needs which is only one group of needs amongst inter-connected stakeholders An increasing number of companies now base their price on the external customer’s perceived value Kortge and Okongwo (1993) suggest that organisations must deliver the value promised by their value proposition, and the customer must perceive this value Understanding what buyers value within a given offering, creating value for them, and then managing it over time have long been recognised as essential elements of every market-oriented firm’s core business strategy (Drucker, 1985; Porter, 1985; Slater and Narver, 1998)

Current research is neither concerned with the value of a customer to the organisation in the long-term nor the value that an organisation provides to its external customers Rather, it restricts its focus on the value that results from internal transactions, only

One of the key advantages of understanding how value is created in internal market structures is that the managers can make better business decisions on how

to expand service activities, or how to reduce activity levels through out-sourcing Marketing Science Institute (MSI) has included customer value in the list of research priorities, and the Institute for the Study of Business Markets at the Pennsylvania State University and the centre for Business and Industrial Marketing (CBIM) at Georgia State University gave special attention to business-to-business marketing and integrated customer value research in their research programs

The concept of value is examined mostly either from the external customer’s or the supplier’s perspective With the introduction of business process reengineering in the late 1980s, organisations began to focus on the way in which internal processes are being performed and to seek methods to improve efficiency The internal customer value is defined as the difference between the results (benefits) they receive in relation to the total costs both the price and other costs to customers incurred in acquiring the service Zeithaml (1988) points out that the buyers are concerned with the costs of obtaining the perceived benefits because they typically compare costs and benefits before they make purchase decisions As internal services increase, among other things, new questions such as ‘how do we assess or price their value’ would arise (Mills and Ungson, 2001) Although many

researchers agree that external customers today are strongly value oriented

(Heskett et al., 1994; Parasuraman, 1997), it is not yet known if value for internal

customers is deemed equally important or if the internal price charged between divisions does influence the value received by the internal customer

Deming (1986) argues it is imperative that internal systems are aligned to service the external customer with each internal sub-system adding value to others within the organisation that are dependent on it as though the other systems are customers Current knowledge on how price decisions are made by organisations

is limited, particularly in relation to customer value created by organisations (Cressman, 1999) Slater (1997) makes a similar recommendation stating that the value creation should start internally

Gronroos (1981) states that organisational units strive to provide their external customers with better performance, lower costs and other benefits of value, and adds that these units should also provide superior service to their internal customers for similar reasons

1.4 Value chain model and competitive advantage

The value chain analysis (VCA) as devised by Porter (1980) views an organisation

as a chain of inter-connected activities for transforming inputs into outputs that customers value At each stage of the process, value is added to the product or service A firm’s internal value chain begins at the conception stage of the product

or service and ends with the delivery of the final product or service to final consumer

Figure 1.5

Integrated value chains (adapted from Porter, 1985)

Suppliers’ value chains value chain Firm’s internal

Buyers’ value chains

Upstream Value

Firm Value Downstream

Value

The value chain model addresses the linkages among all participants in the value creation process including associations between internal and external customers

by examining every activity, process and function an organisation performs in designing, producing, marketing, delivering and supporting a product or service

Figure 1.6

The generic value chain (Porter, 1985)

The generic value chain (1985) is essentially devised for manufacturing organisations, and provides an important tool to detect customer orientation, particularly to recognise internal as well as external customers Pearce and Robinson (2005) exemplify the value process by reporting that operating personnel are internal customers of the accounting department for useful information and also the purchasing department for quality, timely supplies

When they are served with quality, efficiency and responsiveness, value is added

to their efforts, and is passed on to their internal customers and, eventually, external customers

Despite several authors’ support for the usefulness of the value chain analysis, a survey carried out by Chenhall and Langfield-Smith (1998) covering 140 largest Australian manufacturing firms shows that value chain analysis is adopted by less than half (49%) of the manufacturing companies surveyed This is a relatively low adoption rate among other management accounting practices

The value chain analysis provides an insight and lays down a useful framework which allows the researcher to consider the activities involved in the production of

services Brignall et al (1991) propose that a closer alignment of a service

organisation’s responsibility centres with its value chain might be a source of competitive advantage Likewise, Emmanuel and Mehafdi (1994) suggest that transfer pricing can be examined from a competitive advantage perspective using the value chain

On the average less than 20 percent of company employees come into contact with external customers while the other 80 percent service internal customers that are units with real performance expectations (Brinker, 1994) For this reason, whether internal processes are performed to the internal customers’ satisfaction is important Effectiveness and efficiency realised in performing internal activities can enhance overall service quality and ultimately result in reduced costs (Davis, 2001) Therefore, there is seemingly a relationship between internal orientation and competitive advantage

1.5 Out-sourcing

The notion of internal customer perceived value is also pertinent to out-sourcing decisions Out-sourcing may be defined as buying in services from external suppliers rather than providing such services internally (Ward, 1993) It is agreed that value is relative because it is based on perceptions of the way a service is delivered and on initial customer expectations The key strategic issue in buying internally or out-sourcing is whether an organisation can achieve competitive advantage by performing an activity internally usually cheaper, better or in a more timely fashion or with some unique capability in a sustainable fashion (Quinn and Hilmer, 1994)

Particularly in a business environment where organisations are cost-conscious, and out-sourcing of services, in particular, is growing in popularity, survival of many business units increasingly becomes subject to their ability to out-perform their rivals through distinctive benefits embedded in their offering The role of internal pricing on out-sourcing decisions is discussed in greater depth in Chapter 4

1.6 Pricing issues

Pricing is one of the most contentious areas of industry practice and academic research Although there seems to be an agreement on the importance of pricing for a company (Marn and Rosiello, 1992; Simpson, Siquaw and White, 2002), the manner in which prices, in general, are determined is of concern Samli and Jacobs (1994) consider pricing research to be more complex and less exacting, and as such, most academicians do not seem to find the pricing areas as esoteric

as some other areas of marketing Another issue as regards pricing research is that because there have not been many pricing studies, the motivation for undertaking additional studies may not be present As discussed in greater detail in Chapter 2, empirical evidence exists on the ad hoc nature of price setting in the industry (Wetenhall, 2003; Monroe and Cox, 2001; Buzzell and Gale, 1987)

The evidence from past research reveals that prices are determined by intuition, rules of thumb, outright dogma, top management’s higher wisdom or internal power fights (Simon, 1992)

Given that the pricing practices of businesses generally lack sound analysis, deciding what price to charge for various goods and services sold by one organisational unit to another in the same company is probably one of the complex issues confronting managers These intra-company charges are ultimately reflected in the statement of financial performance or performance reports of the respective divisions

1.6.1 Transfer pricing

The price charged by one segment (sub-unit, department, division) of an organisation for a product or service supplied to another segment of the same organisation is termed the “transfer price” (Horngren and Foster, 1991) Price charged to a subsidiary or allied organisation abroad is termed ’international transfer price” which involves complex taxation issues Pricing goods or services destined to allied organisations within the same organisation and within the same country is called ‘domestic transfer price’ The current research focuses on domestic transfer price

Transfer pricing is a sub-system within the management control systems which provides the focus for all those activities designed to help ensure that overall operating coherence is maintained, and that the organisation retains a capability to survive in its uncertain environment (Otley, 1994) A sound transfer pricing system

is therefore considered essential for the optimal allocation of resources and provision of appropriate measures of divisional profit measurement (Tang, 1992) Through performance evaluation, the information used to decide where to buy and where to sell provides an input to other decisions, such as the continuing or discontinuing of a product or service, the expansion or contraction of the division, the promotion or sacking of the manager

These decisions have some effect on resource allocation within the firm Therefore, the monetary value placed on the internal good or service may have far-reaching consequences (Radebaugh and Gray, 1997)

According to Cooper and Slagmulder (1998), establishing an accurate transfer pricing system is a necessary first step which should be supplemented by intra-organisational cost management system and micro-profit centres Although there

is consensus on how important it is to get the transfer price right (Benke and Edwards, 1980; Eccles, 1985; Adler, 1996), there is also evidence that, like prices

in general, determination of transfer prices, too, is largely arbitrary (Emmanuel and Mehafdi, 1994) Transfer pricing is generally considered within a fiscal context

In addition to the rather casual approach of firms evidenced in the literature, another dimension of internal transaction, whether internal price does in any way affects the value received by the internal buyer is first raised by Emmanuel and Mehafdi (1994) They suggest that transfer pricing should be examined from a competitive advantage perspective using the value chain The issue of transfer pricing is important for organisations because transfer pricing practices affect economic decisions, which in turn affect corporate performance Transfer pricing practices also have a bearing on performance measurement, evaluation and reward, which influence perception of fairness by individual managers (Eccles, 1985) If the basis of underlying transfer prices is flawed, the subsequent decisions regarding the allocation of resources are also likely to be flawed, leading to some efficient units being closed while less efficient operations are expanded (Ward, 1993)

1.7 Service businesses

Kotler (2003) defines service as ‘any activity or benefit that one party can offer to another, that is essentially intangible and does not result in the ownership of anything” A more detailed discussion on several definitions of service and major differences between goods and services is presented in Chapter 2

The decision to conduct this research in a services setting was made for two reasons First, the services industry which, according to Australian Bureau of Statistics’ classification (ABS 2004) comprises accommodation, transportation and storage, finance and insurance, property and business services, education, health and community, cultural and recreation, personal and other services has been the fastest growing sector for the past few decades with the increase predicted to continue Services represent around 25-30 percent of world trade, and are growing

at a rate faster than trade in manufactured goods In addition, services account for two-thirds to three-quarters of the gross national product, not only in the United States, but also in many other highly developed industrial nations (Lovelock, Patterson & Walker, 2002) In Australia, the services sector generated 78 percent

of GDP in 2000/01 and provided employment for approximately 82 percent of the work force (ABS cat no.5206) In the USA, 80 percent of the work force is employed in services (Zeithaml & Bitner, 2000) whereas in New Zealand, the

service industry employs 82 percent of the work force (McColl-Kennedy, 2003)

The second reason is that, currently, no knowledge exists as to the implications of internal pricing of services on internal value creation Despite the growing importance of services in developed economies, most of the empirical studies on transfer pricing have concentrated on physical goods and manufacturing organisations The need for more research into under-researched costing issues in

services is obvious (Brignall et al., 1991) Keegan and Howard (1988) argue that

transfer pricing in service organisations is complex and challenging World-wide, the present knowledge on transfer pricing practices in service organisations is patchy, and very little is known about service businesses’ transfer pricing practices

in Australia It is also not known if transfer price has any bearing on the perceived value for internal customer

1.8 Summary

Although price is recognised as a major choice criterion in industrial purchasing decisions, evidently, it has received little empirical attention in industrial buying research (Kelly and Coaker, 1976) Furthermore, limited empirical work appears to exist on value for internal customers As discussed in more depth in Chapter 2, the present knowledge on transfer pricing practices in service organisations is very limited Therefore, this research attempts to integrate domestic transfer price with internal customer value for the first time in the accounting literature, and thus offers

a new perspective for understanding the implications of domestic transfer price on the value generated during internal exchange of services Scapens (1990) indicated that there is a considerable difference between the theory of management accounting as portrayed in current textbooks and management accounting practice Therefore, there is a need for researchers to investigate the nature of existing management accounting practice in order to understand better the situation and contexts in which particular theoretical techniques may be appropriate in practice Further, some authors (Otley, 1980; Choudry, 1986) complain that management accounting research had very little impact on practice Drury and Dugdale (1992) attribute this perceived gap between management accounting theory and management accounting practice to the lack of in-depth company studies or surveys of management accounting practice Finally, Johnson and Kaplan (1987) criticise management accounting research, and claim that management accounting research and textbooks have concentrated on developing sophisticated models in simplified production settings that bear little relation to problems faced by practitioners

The remainder of this thesis is organized as follows Chapter discusses the relevant literature In Chapter 3, theoretical frameworks underpinning this study and research philosophy and research methodology are outlined Chapter 4 focuses on analysis of data and compares and contrasts findings of this study with the literature Finally, Chapter 5 presents a summary of key findings, contributions

of this research, limitations of this research and implications for further research

CHAPTER 2: LITERATURE REVIEW

This research represents the first attempt in the accounting literature to integrate the frameworks of transfer price and value creation for internal customer and, consequently, no literature exists on the interplay between transfer price and internal customer value The literature specific to the current research on (1) pricing and transfer pricing; (2) external versus internal markets; (3) value; and (4) value chain analysis and competitive advantage is critically reviewed

2.1 Pricing

The price is defined as “the summation of all sacrifices made by a consumer in order to experience the benefits of a product (Buttle, 1997) The Importance of getting the price right in maximising profits is stressed by McKinsey consultants Marn and Rosiello (1992) who study 2462 companies and report that a one percent price improvement generates an average of 11.1 percent increase in profits Although appropriately pricing goods and services is recognised as the basic and critical decision facing an organisation (Morris, 1987), price determination is still the most inconspicuous, secretive, sacrosanct, and least rational of the marketing strategy components (Abratt and Pitt, 1985; Morris and Fuller, 1989) In addition, prior researches on pricing prove to be of very little practical help for most

managers (Bonoma et al., 1988)

2.1.1 Current pricing practices and issues

McKinsey and Company’s Global Survey of Business Executives (2005) finds that pricing is now one of the most pressing concerns for business However, Simpson, Sikuaw and White (2002) survey purchasing managers of 110 of the top Fortune

500 companies to ascertain, among other things, if price is an important criterion in their supplier evaluation process

They find that only a quarter of respondents employ pricing as part of their evaluations of suppliers, and only 24 percent of those respondents employing evaluative weighting systems assign weights to price It is important to note that this finding applies to business to business transactions

Although price directly affects revenues and is a reflection of a product’s positioning in the market place, previous studies indicate that the pricing issue is not being given the appropriate attention by firms that it deserves In setting prices, firms are typically confronted with two issues: (1) appropriating rents; and (2) balancing competing internal interests; hence, pricing capability involves systems and processes that a firm develops to address these two issues (Dutta, Zbaracki and Bergen, 2003) According to Nagle and Cressman (2002), few companies proactively manage their businesses to foster more profitable pricing, and pricing strategically involves managing customers’ expectations to induce them to pay for the value they receive Nagle and Cressman (2002) also conclude that in firms, often, no one can identify who in the organisation is responsible for setting prices

or evaluating the effects of prices on the overall profitability of the organisation Nagle and Cressman (2002) report that in some cases, responsibility for pricing rests with no one, at all, and argue that because price metrics do not adequately capture value, customers may object or refuse to pay the price demanded by the organisation because they do not find sufficient value to justify the price

As discussed in the following paragraphs, extant literature supports the view that the marketing concept’s basic premise of understanding customers’ value drivers and providing value propositions accordingly is being consistently ignored by firms According to Monroe and Cox (2001) the data relating to how companies go about pricing suggest that many companies make pricing decisions and changes in pricing policy without an established process for managing the pricing activity

As a result, they conclude that most companies do not even have a serious pricing strategy and do not conduct pricing research to develop an appropriate strategy McKinsey & Company’s Pricing Benchmark Survey shows that only about 15% of companies do pricing research, and in most firms, prices are determined by intuition, rules of thumb, outright dogma, top management’s higher wisdom or internal power fights (Simon, 1992)

Berry and Yadav (1996) demonstrate that, more than any other area, pricing for external customers is dominated by ‘gut feel” and “personal prejudice” rather than

a careful calculation of what the market can bear, and conclude that the pricing of services in the United States is a “mess” Despite increasing competition, survey

of pricing practices on a usable sample size of 270 manufacturing firms in the USA, Noble and Gruca (1999) find that cost-based pricing is still the dominant pricing strategy Cost-based pricing method is considered as an inward oriented strategy that involves company and product considerations and ignores requirements of the external customer and competitive conditions (Day and Nedungadi, 1994)

On the other hand, some firms assume that customers care only about price, and

as a result, they resort to an endless spiral of cost-cutting and price-cutting (Buzzell and Gale, 1987) While acknowledging the importance of costs in setting prices, it

is crucial to understand that prices alone do not reflect the value delivered to customers, and Cressman (1999) claims warning bells are ringing for practitioners for ignoring value in their pricing strategy

2.1.2 Reference Prices

Studies that examine whether firms use benchmarking or internal reference prices

in evaluating prices are very few in number Bolton and Drew (1991) contend that

the customer’s assessment of value depends on the customer’s frame of reference Thompson, Strickland and Gamble (2005) show that many companies today are benchmarking their costs of performing a given activity against competitors’ costs and/or against the costs of a non-competitor in another industry that effectively and efficiently performs much the same activity) Thompson et al.’s (2005) conclusion however is anecdotal For example, Day’s (1990) empirical study finds that in many businesses, less than 15 percent of effective management time is directed to customers, while no more than 5 percent is devoted to thinking about competitors with the remaining 80 percent spent on internal matters that only indirectly deal with customers or competitors The evidence demonstrates that most businesses do not focus enough on the two key elements that will determine success: customers and competitors (Day, 1990)

2.1.3 Services and pricing of services

Manufacturing industries can be defined as being those involved in the making of tangible articles or material that did not exist before, by the use of physical labour and/or mechanical power (Ward, 1993) Distinctive features of services require an approach to pricing that is significantly different from the pricing of goods Definitions of service, and what constitutes a service, range from the narrow to the broad In 1960, the Definitions Committee of the American Marketing Association defined services as “activities, benefits or satisfactions which are offered for sale,

or are provided in connection with the sale of goods” The definition of what constitutes a service also varies across the service sector Clark (1940) divides all economies into three sectors: primary (agriculture), secondary (manufacturing) and tertiary (services) Services tend to be more non-standardised, heterogeneous, and customised at the point of sale than products (Lovelock, 1984) The service sector composed three parts – domestic related services (food and lodging); business services and others (including health care, recreation and education) There are difficulties to be precise about what is a good and what is a service

For instance, Shostack (1977) notes that there few pure goods or services because most products exhibit varying degree of tangible and intangible elements, and services are intangible elements On the other hand, Parasuraman (1997) adopts a different approach by suggesting that if a product’s core benefit is more tangible than intangible, then the product should be considered a good; and if it is more intangible than tangible, it should be considered a service

A service is an intangible item that depends to some extent on interaction between the buyer and seller for its provision (Grosse, 1996) For Gronroos (2001), the central distinguishing feature of services from goods is the fact that services are activities rather than things Among distinguishing characteristics of services, Gronroos (1982) and Lovelock (1983) point to the intangibility aspect of services, simultaneous production and consumption (processes) and interaction of supplier and customer during the process of service delivery